Module 2 Critical Thinking FIN300-1

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Ratio Analysis and Interpretation Colorado State University Global FIN300-1: Principles of Finance for the Private Sector Prof. Brian Weaver January 1 st , 2023 1

2 Ratio Analysis and Interpretation There are a variety of ratios that can be computed and used to analyze the information within an organization’s financial statements. By using the reported numbers within the income statement as well as the balance sheet, we can determine more about profitability, activity, liquidity, and debt for a firm. More often than not, these ratios are used to forecast profitability, implement new changes, and analyze any departments or functions of the business that need to be adjusted. According to BDC (n.d), analyzing financial ratios allows an organization to better understand their financial structure and health. These ratios can not only help in the analysis of the company’s performance, but can also assist in comparing to competitors or market averages. Knowing these different financial aspects is useful in planning and adjusting for better profitability in the future. Average Collection Period Average Collection Period = Accounts Receivable ÷ Annual Sales ÷ 365 2015 2016 2017 2018 1,280,000 40,339,000 365 1,162,000 39,528,000 365 1,347,000 39,403,000 365 1,049,000 42,151,000 365 1,280,000 110,518 1,162,000 108,296 1,347,000 107,953 1,049,000 115,482 =11.6 Days =10.7 Days =12.5 Days =9.1 Days Total Asset Turnover Total Asset Turnover = Sales ÷ Total Assets 2015 2016 2017 2018 40,339,000 15,245,000 39,528,000 13,519,000 39,403,000 13,856,000 42,151,000 13,049,000 =2.65 Times Per Year =2.92 Times Per Year =2.84 Times Per Year =3.23 Times Per Year Inventory Turnover

3 Inventory Turnover = Cost of Goods Sold ÷ Invento ry 2015 2016 2017 2018 31,292,000 5,174,000 30,334,000 5,051,000 29,963,000 4,864,000 32,275,000 5,209,000 =6.05 Times Per Year =6.01 Times Per Year =6.16 Times Per Year =6.19 Times Per Year Days in Inventory Average Age of Inventory = 365 ÷ Inventory Turnover 2015 2016 2017 2018 365 6.05 365 6.01 365 6.16 365 6.19 =60.3 Days =60.7 Days =59.3 Days =58.9 Days Activity Assessment Using the information from both the balance sheet and income statement, I was able to determine that the activity for Best Buy Co., Inc has improved over the four year period. The activity ratios of an organization help in understanding how different accounts are performing. According to Gitman and Zutter (2014), activity ratios measure the rate at which various accounts are converted into sales, cash, inflows, or outflows. First, looking at the average collection period, or the amount of time to collect accounts receivable, we can see that the rate has improved for Best Buy Co., Inc throughout the four year period. The drop in the ratio each year reflects that there is less time elapsed before the collection of receivables. The total asset turnover ratio allows us to measure the efficiency in which assets are used to generate sales. According to Fairfield and Yohn (2001), differences in profitability can be traced to changes in asset turnover as well as the profit margin, hence why the activity ratios are used hand in hand with profitability ratios. Looking at the asset turnover ratio for Best Buy Co., Inc for the years 2015-2018 show an improvement in the usefulness of its assets, as the turnover rate trickled upwards each year. The inventory turnover and days in inventory ratios allow us to analyze the

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4 activity or liquidity of an organization’s inventory as well as the average number of days’ sales in inventory. These ratios reflect an increasing turnover rate for the inventory as well as less time spent in inventory over the years meaning that the company has improved its utilization of their inventory. Gross Profit Margin Gross Profit Margin = Gross Profits ÷ Sales 2015 2016 2017 2018 9,047,000 40,339,000 9,194,000 39,528,000 9,440,000 39,403,000 9,876,000 42,151,000 =22.4% =23.2% =23.9% =23.4% Operating Profit Margin Operating Profit Margin = Operating Profits ÷ Sales 2015 2016 2017 2018 1,497,000 40,339,000 1,582,000 39,528,000 1,947,000 39,403,000 1,965,000 42,151,000 =3.7% =4% =4.9% =4.6% Net Profit Margin Net Profit Margin = Earnings Available for Common Stockholders ÷ Sales 2015 2016 2017 2018 1,143,000 40,339,000 817,000 39,528,000 1,156,000 39,403,000 925,000 42,151,000 =2.8% =2.1% =2.9% =2.2% Profitability Assessment Although many of these ratios are interconnected, there are a few specific ones that help in analyzing profitability of a company and its operations. The ratios that can be looked at for measuring profitability are the gross profit margin, operating profit margin, net profit margin, earnings per share, return on total assets, and return on equity. According to Bond and Auerbach

5 (n.d.), the profitability ratios that should be looked at regularly by an organization are the gross profit margin ratio, the operating profit margin ratio, and the net profit margin ratio. Focusing on the profitability ratios is useful in a combined analysis which allows companies to compare each year’s performance to both industry norms and previous accounting periods. The profitability margins for Best Buy Co., Inc showed improvement over the four year period, but one of the ratios saw some fluctuation. The gross profit margins for Best Buy Co., Inc show improvement for the first three years, then a slight drop in the final year. As is with all profit margins, the higher the better. The operating profit margin additionally saw a steady rise from 2015-2017 and a slight drop in 2018. Although it was slightly lower, it’s not a sign of poor performance for the years. The last ratio that was analyzed was a bit questionable. The net profit margin saw a lot of fluctuation throughout the four years. Best Buy Co., Inc started with a high net profit margin ratio in 2015, then a drop in 2016, another rise in 2017, and a drop back in 2018. If we only pay attention to the net profit margins what does this say about their performance? The profitability ratios are always more desirable when they are higher, but small fluctuations are okay here too. There are plenty of factors that effect this ratio such as taxes, interest, and dividends. Conclusion Ratio analysis and interpretation are essential for business owners and investors alike. Using these ratios can not only help current investors but potential future investors by seeing how the company performs year by year as well as in comparison to similar or competition companies. These ratios used together can help alleviate any problematic sectors of the business’ functions and help to improve the results produced each year.

6 References BDC. (n.d). 4 ways to assess your business performance using financial ratios. (Accessed December 29, 2022) https://www.bdc.ca/en/articles-tools/money-finance/manage- finances/financial-ratios-4-ways-assess-business Bond, E. & Auerbach, A. (n.d.). How to analyze profitability. (Accessed December 29, 2022) https://edwardlowe.org/how-to-analyze-profitability-2/ Fairfield, P. M., & Yohn, T. (2001). Using asset turnover and profit margin to forecast changes in profitability. Review of Accounting Studies, 6(4), 371-385. https://doi.org/10.1023/A:1012430513430 Gitman, L. J., & Zutter, C. J. (2014). Principles of Managerial Finance, Brief (7th ed.). Pearson Learning Solutions. https://bookshelf.vitalsource.com/books/9781323053355

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